New internet businesses are transforming dusty old industries. The current wave includes Uber (hire cars), Airbnb (accommodation) and Freelancer (labour services).

But there have been plenty of others over the past twenty years. Email has bankrupted postal services. Skype put a rocket under telephone companies. Google has transformed information and advertising.

There will be plenty more in the near future.

How do the new wave of internet businesses fit into regulatory structures that were designed for a bricks-and-mortar world?

Badly!

The Productivity Commission is currently investigating the barriers facing new businesses. It is taking particular interest in digital start-ups. However, the problems go much deeper.

There are three regulatory challenges for Australia when dealing with internet businesses in the sharing economy:

How do we protect consumer interests?

How do we avoid vested interests using regulation to stop entry and competition?

How do we prepare for future competition issues?

Consumer protection

Your Uber car is involved in an accident. The driver has standard insurance, not commercial insurance. So any property loss is not covered.

You rent an Airbnb apartment only to find out that the apartment has been sublet in violation of the lease. You are evicted.

You lease out your apartment on Airbnb. A few days later the police call. The apartment has just been raided. The tenants were using it as a pop-up brothel.

Commercial arrangements can go wrong for any business. Internet businesses are neither more nor less likely to raise problems. However, from the consumers’ perspective, these businesses operate outside normal guidelines because they claim to be matching platforms, not direct service providers.

Uber doesn’t employ its drivers. It checks them and uses a ratings system to maintain standards, but it would claim that it is not formally liable for poor driver conduct. Similarly, Airbnb states that local laws are the local service provider’s problem.

Is this legal and is it good enough?

The Courts will check the legality. But relevant precedent is probably years away. Further, Court decisions may be inconsistent between jurisdictions. In Australia, the High Court ruled that Google is simply a publisher and not liable for third-party advertising content. However, the European ‘right to be forgotten’ laws make Google liable for third party web-pages that can be accessed through its search engine.

The platforms may ask us to trust them. After all, their reputation depends on the quality of the services provided through their platforms. But this is not good enough. Relying on the market and reputation to sort out consumer protection issues can lead to lots of damage on the way. And despite the best efforts of a platform, bad operators will get onto the system.

Light-handed accreditation regulation will also be imperfect, but it can help the internet platforms work better for consumers.

So Uber drivers may need to be accredited, to ensure they have safe cars and appropriate insurance. Tripadvisor reviews will need to be presented with appropriate caveats. Airbnb apartments should not be advertised in a way that is misleading and deceptive. And the platforms cannot simply shrug their shoulders and say, “not our problem”. The platform will have some responsibility to check that their suppliers meet appropriate legal standards.

The platforms themselves should recognise this, which perhaps explains Uber’s recent change of heart. The alternative is either to operate outside the law and be sued to death, or to watch a new regulatory bureaucracy grow around their business. Cooperation and compliance, death by lawsuit or strangulation by red tape. They are the options facing the internet businesses.

Vested interest regulation.

No business likes competition. Existing bricks and mortar businesses will not simply yield to more efficient internet-based businesses. They will put up a fight and part of the fight will be to try and use regulation to strangle the new businesses.

Of course, incumbents will not put it that way. The official line will be about protecting consumers. So when taxi license owners protest against Uber or hotel chains complain about Airbnb, the language is about consumer interest, not profit protection.

But it is competition that delivers value for consumers. Governments need to separate out self-interested claims by incumbents from real consumer concerns.

This is not easy. Vested interests will blow out of proportion any incident involving the internet entrant while ignoring similar incidents that have occurred through their own service.

Governments need to have the courage and insight to recognise incumbent rent seeking and to hold out against it. That can be difficult. The bricks-and-mortar businesses fighting against the entrants may be large (think Harvey Norman and the internet tax debate), and will have a lot at stake.

But as Andrew Leigh has noted:

“[F]orward-thinking regulators are increasingly realising that the sharing economy can deliver big benefits for consumers. … the benefits are real and the risks are manageable.“

Competition Rules

In technology, today’s small entrants are tomorrow’s dominant firms. Shareholders in Uber, Airbnb, Tripadvisor, Freelancer, and so on are investing their money in the hope of a profit. And if they succeed by helping consumers, then that is fantastic. However, as these businesses grow, they may be tempted to make easy money through market power rather than competition.

For example, Uber currently does not require that drivers are exclusive. As David Plouffe of Uber noted at a recent Grattan Institute event, a driver can drive for Uber, Lyft, or anyone else. But will these rules continue to hold if Uber (or someone else) grows to dominate the ride sharing market?

These concerns are not hypothetical. We have seen large businesses use various tactics, including exclusivity arrangements, to make new entry hard. In supermarkets, Aldi had a hard time expanding in Australia due to exclusivity arrangements between the major chains and the shopping centres. These were eliminated after the ACCC’s 2008 grocery inquiry. Since then, Aldi has rapidly expanded.

Internet based businesses that grow dominant may try similar tactics.

This means that competition regulators will need to be watchful. In particular, the terms and conditions used in contracts between platforms and both suppliers and buyers need careful scrutiny. If they involve exclusivity arrangements or ‘reference competitors’ say through ‘most favoured customer’ pricing, then the alarm bells should start ringing.

Two caveats.

First, these concerns hold for all large businesses, not just those on the internet.

Second, in fast changing areas of technology, attempts by incumbents to hold out entry are often doomed to failure. As historic antitrust cases against IBM and Microsoft in the US illustrate, the market will often act faster than regulators and the courts.

Bring internet businesses inside the regulatory tent

New businesses built on internet-based technologies have, are and will continue to transform many industries. The result is better services at cheaper prices for all Australians.

But these businesses cannot and do not live in a regulatory vacuum. They cannot grow as regulatory cowboys. But, vested interests will be more than happy to strangle them with red tape. Getting the balance right will be difficult for both government and regulators. But if we get it right, the potential gains are huge.

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Standards are a key part of technical progress and for the increased use of renewable energy.

Solar power provides an obvious example. If a photo-voltaic unit is used to put power back into the electricity grid, then the power needs to satisfy the standards for the grid in terms of voltage, cycles-per-second, and so on. These standards have been established for traditional generation and transmission and will continue for solar systems and local battery storage.

However, some new technology will not be able to rely on existing standards. A simple example is electric vehicles and recharging stations.

Standards will be a key to the success or failure of all-electric vehicles. An electric vehicle may be used simply for urban travel with overnight charging. But the vehicle is a lot more useful if it can be used over long distances and can be easily and rapidly charged at convenient locations during a journey.

Currently hybrids are used to solve this problem. A traditional petrol engine is used to back up (and potentially recharge) the electric engine. But hybrids are more like fuel-efficient traditional cars, not electric vehicles.

All electric vehicles will only push out traditional petrol cars if they have a longer range and can access a network of recharging stations.

Unfortunately, building a network of recharging stations is an expensive up-front investment. It is only useful (or profitable) to build a network of recharging stations if they are compatible with a wide range of electric vehicles and there are enough of these vehicles in use.

Economics has long analysed the problem of standard setting, and there are a range of potential solutions.

A government can simply mandate a particular standard and require that manufacturers selling in their country use that standard. That solution can lead to a uniform standard if other countries follow. However, governments can easily choose standards that turn out not to be the best for manufacturers or consumers. And if the rest of the world does not follow the lead country then it can be left behind.

For example, if you get annoyed by having to use adaptors for electric appliances and being careful about the voltage while travelling overseas, then thank the governments who set different standards. Similarly, if you ever wondered why railways in NSW, Queensland and Victoria all have different widths (or gauges) thank government standard setting. The colonial governments all set different standards, ruling out a national railway network.

Alternatively, the standard setting can be left to the market. Products battle out until one emerges as the dominant standard and the others are driven out. But this has three problems.

First, there is waste as consumers get stuck with the ‘wrong’ product that becomes obsolete. (Do you or your parents have a Betamax video player sitting in a broom closet somewhere?)
Second, it can lead to good products failing, as consumers wait to see which standard wins before they are willing to buy any product. Third, the winner may not be the best standard.

Finally, a consortium can try and set the standard across a number of businesses or countries. This approach is used in mobile phones. However, standard setting organizations controlled by business may not necessarily choose the best standard. Each member will be keen to promote a standard that uses its own intellectual property. And, if successful, the companies may choose to profit from their patents by charging monopoly prices. China recently fined Qualcomm for exactly that behaviour.

Standard setting organizations cannot ignore business. After all, it is the individual manufacturers who need to adopt a standard and incorporate it into their products. A standard setting body purely based on government and high-minded engineers may choose a high-cost standard that is impractical and no one wants or uses.

Put simply, there is no easy answer to the best way to set standards for new technology, including recharging stations for electric vehicles.

But we need to work out an approach soon. The alternative will be a range of ad hoc and inconsistent approaches adopted around the world.

For example, China has gone with a government-set standard. It has built a series of fast recharging stations every 25 kms from Beijing to Shanghai.

But the standard used by the recharging stations means that, at present, they can only be used for four types of vehicles. Unsurprisingly these are all vehicles either produced by Chinese companies or by international firms that have joint ventures with Chinese companies. The recharging stations use a standard that is incompatible, for example, with Tesla and BMW electric vehicles.

China may hope that its ‘first mover’ approach forces other countries to adopt the same standard. It may be right. But history is littered with first-mover losers in standard setting (for example, the standard set for analogue televisions).

The major manufacturing countries could get together at a government level to try and establish a standard. This may take some doing. The US and EU appear to rarely agree on anything when it comes to economics and technology. Add in China, with a vested interest in protecting its existing system, Japan and others, and I suspect we will still be waiting for agreement on a standard when cars (and possibly people) have become obsolete.

Alternatively, government could facilitate a manufacturer-based standard-setting organization that includes the major producers of electric vehicles such as Tesla, BMW, Honda and GM. ‘Traditional’ car makers will not be invited.

This approach may not lead to the best standard. It may lead to potential abuse of market power and future competition cases. But the manufacturers themselves have the greatest interest in quickly developing a global standard for recharging. This will mean they can sell more electric vehicles and make more profit. And this is a situation where the profits of the makers of electric cars, the interests of the public in more usable electric cars, and a better environment, are all aligned.

On December 14th, the Minister for Communications, Malcolm Turnbull, released new rules requiring all providers of high-speed broadband services to be vertically separated. These rules were aimed at TPG, which was rolling out fibre-to-the-basement (FTTB) in urban apartment buildings. FTTB would compete against the NBN and potentially undermine the ability of the NBN to use high city prices to subsidise the bush.

The new license conditions had their effect. They stopped TPG, at least temporarily.

Fortunately, the Carrier License Conditions were only part of the reforms. The government is also moving to free up the NBN by allowing for regulated price caps rather than fixed prices. This means the NBN will be able to drop its price to match competition when it needs to do so. But it is prevented from recovering the lost revenues by raising prices elsewhere. The price cap stops that.

But the biggest potential reform is making transparent the cross subsidy that is current hidden in the NBN uniform pricing. This means that all high speed broadband providers in urban Australia, whether the NBN, TPG, Telstra or someone else, will pay their fair share of the contribution to broadband in the bush. As Turnbull notes:

“Having a transparent levy to cover the massive subsidy to the bush (via the fixed wireless and satellite services) does NOT increase the cost of the NBN - it simply makes transparent and explicit what had previously been hidden in its prices.
Such an approach would, however, ensure competing broadband suppliers make a contribution to the subsidised services in the bush too.“

The levy would, on Turnbull’s numbers, be about “$6.70 per user per month for every city customer”.

Overall, as I have argued before, making the cross subsidy transparent is a good thing. Indeed, I would prefer the government to go further and to explicitly fund broadband to the bush through general tax revenue.

However, a transparent levy is a good compromise. It ensures the long-term viability of high-quality internet to the bush. But, as I discuss on Crosstalk, before we get too excited a key question needs to be addressed. How will the levy be set and who will set it?

There are two ways forward for the government. The good way is ‘set and forget’. The levy is set at $6.70, CPI adjusted for each urban customer. The levy does not change depending on whether the NBN roll out is well managed, runs over or under budget, or anything else. It may or may not cover the full actual cost of broadband to the bush. If it raises more money than needed, great. The government gets a bit more revenue. If it falls under budget, then NBNCo will need to explain why to the Federal government. And the government will bear the risk.

The alternative is to try to set a regulated levy to ‘correctly’ recover the cost of broadband to the bush. This approach is costly and doomed to failure.

Under this alternative approach, a regulator, such as the ACCC, would carry out an investigation into the ‘true cost’ of ‘efficiently providing’ high speed internet access in the bush. The inquiry would be held every three or five years, and set the levy until the next inquiry. The inquiry would involve submissions, public forums and would require elaborate economic and engineering modelling. There would be esoteric arguments about the cost of capital, appropriate depreciation and forecasts of demand. Lawyers would be called in to determine the exact meaning of relevant words and to debate the alternatives. Any decision would need an appeals process to ensure a fair outcome.

The regulatory approach would be expensive. Each inquiry would take around 12 to 18 months to complete. Appeals would add on at least another year to the process. By the time a final decision on the levy is made it would just about be time to start the process again. It would make some economists, engineers and lawyers rich. But the end result would be little better than a guess.

How do I know that a regulatory approach would lead to such a mess? Because that is where we have been for the past twenty years. The NBN is meant to break the regulatory cycle that kept Telstra and the ACCC (and before it, AUSTEL) at loggerheads.

So two cheers for Turnbull. It is a sensible and brave political move to float the idea of a transparent levy for broadband to the bush.

But I will hold back the third cheer until we see how the levy is to be determined.